Almost two years after Lehman Brothers Holdings Inc.’s
failure caused world markets to seize up, Pacific Investment
Management Co. is planning a fund that will offer protection to
investors against market declines of more than 15 percent.
Morgan Stanley strategists estimate demand for hedges against
such cataclysms helped drive as much as a fivefold increase last
quarter in trading of credit derivatives that speculate on
market volatility.

The efforts to protect against another disaster, which
helped drive up the relative costs of the most bearish credit
derivatives to the highest in two years, show that investors’
psyches still haven’t recovered from the Lehman bankruptcy on
Sept. 15, 2008, which erased $20.3 trillion in stock market
value worldwide and caused credit markets to freeze.

“Everyone is starting to realize that this is going to be
a much longer, much more difficult path to recovery,” said
William Cunningham, head of credit strategies and fixed-income
research at Boston-based State Street Corp.’s investment unit,
which oversees almost $2 trillion. “It’s really quite fragile
and vulnerable in a way that we haven’t seen in our lifetime.”

Demand for protection against so-called tail risks, extreme
market moves that Wall Street’s financial models fail to detect,
is increasing as investors react to events such as the May 6
stock market rout that briefly sent the Dow Jones Industrial
Average down almost 1,000 points, or Greece’s sovereign debt
crisis, which on June 7 sent the euro to a four-year low against
the U.S. dollar.

Black Swans

For much of the year before Lehman’s collapse, Nassim
Nicholas Taleb warned bankers that they relied too much on
probability models and had become blind to potential
catastrophes, which he labeled black swans, a reference to the
widely held belief that only white swans existed -- until black
ones were discovered in Australia in 1697. His 2007 book, “The
Black Swan,” contends tail risks are becoming more severe.

To hedge against tail risks, investors usually look for the
cheapest insurance against a cataclysmic market sell-off, mainly
through derivatives that are expected to multiply in value as
prices plummet for everything from stocks to the Australian
dollar.

The Indiana Public Employees Retirement Fund, with $14.1
billion of assets, asked financial institutions in January to
send information on a tail-risk management program that would
protect it against “an extreme market downturn,” according to
a request for information on the manager’s website.

Tail-Risk Pioneer

The term long-tail risk is derived from the outlying points
on bell-shaped curves that forecasters use to plot the
probability of losses or gains in a given market. The most
probable outcomes lie at the center. The least probable, such as
a decline of 5 percent in an index that most days rises or falls
by less than 0.25 percent, are plotted at the “tails” of the
curve. The greater the deviation, the longer the tail.

Taleb helped pioneer tail-risk hedging in the 1980s,
trading options for banks including First Boston Inc., now part
of Credit Suisse Group AG. Taleb built what he later termed a
“massive” position in options on Eurodollar futures when the
stock market crashed on Oct. 19, 1987. The Dow’s biggest one-day
drop in history prompted the Federal Reserve to pump liquidity
into the banking system, lowering interbank borrowing rates and
causing the futures to surge.

‘Drop Like Flies’

Pimco, manager of the world’s biggest bond fund, Deutsche
Bank AG and Citigroup Inc. are among firms offering clients
tail-risk protection, either through funds or traded instruments
that act as hedges. Taleb said few will have the stomach to
stick with the strategy.

“They will drop like flies,” said Taleb, now a professor
at New York University’s Polytechnic Institute, who in 1999 set
up tail-risk hedge fund Empirica LLC, which he ran for six
years. “They and their customers will give up at some point.
I’ve seen it before.”

Besides the sovereign debt strains in Europe that led to
Greece, Spain and Portugal having their credit ratings reduced,
investors such as Kyle Bass, who made $500 million three years
ago on the U.S. subprime collapse, are concerned that even top-ranked governments may face hyperinflation from bailing out the
global financial system. The U.S. has $8 trillion of public debt
outstanding, up from less than $4.5 trillion in mid-2007.

China is grappling with a property bubble as its world-leading 11.9 percent economic expansion slows. Prices in 70
cities rose 11.4 percent in June from a year earlier following a
record 12.8 percent in April and 12.4 percent in May, according
to China Information News.

Market Liquidity

At the same time, traders say that market liquidity, or the
ability of investors to easily trade in and out of positions as
markets change, hasn’t fully recovered from the Lehman collapse.
Even though the amount of Treasuries outstanding has increased
about 75 percent the past three years, the average daily trading
volume of the securities among the primary dealers has declined
about 12 percent, according to Fed data.

“In some of these asset classes, it’s just not practical
to reduce risk by selling given the lack of risk appetite and
illiquidity,” said J.J. McKoan, co-director of global credit
investments in New York at AllianceBernstein LP, where he helps
manage $199 billion in fixed-income assets.

Improbable Occurs

Investors were reminded that the improbable can happen by
the events of September 2008 -- from the government seizure of
mortgage-finance companies Fannie Mae and Freddie Mac to
Lehman’s bankruptcy and the near-failure of American
International Group Inc., once the world’s largest insurer.
Defaults on mortgages given to the least creditworthy borrowers
drove financial institutions worldwide to take $1.8 trillion in
writedowns and losses.

The seemingly growing occurrences of events that fall on
the fringes of probability are prompting pension fund managers
and other institutional investors -- who once shunned costly
hedging strategies -- to reconsider. And they’re doing it even
as economists predict the U.S. economy will grow an average of
almost 3 percent through 2012 and as analysts forecast the
Standard & Poor’s 500 Index will gain 17 percent through year-end.

“People are trying to move beyond historic notions that
tail risk events are so infrequent on the one hand, and so
extreme on the other hand, that there is nothing you can do
about them,” said Eugene Ludwig, who started a Washington-based
risk management firm called Promontory Financial Group after
serving as U.S. Comptroller of the Currency under former
President Bill Clinton.

‘New Normal’

Pimco Chief Executive Officer Mohamed El-Erian developed
tail-risk strategies when he was manager of Harvard University’s
endowment in 2006 and 2007, and wrote about the importance of
such hedging in his book, “When Markets Collide.”

El-Erian, who describes America’s economic future with the
term “new normal,” advocated the strategy he applied at
Harvard on returning to Pimco in January 2008. Pimco, which
manages about $1.1 trillion, opened its first mutual fund aimed
at minimizing risks from systemic shocks that October. The Pimco
Global Multi-Asset Fund is co-managed by El-Erian and Vineer
Bhansali.

Pimco, the Newport Beach, California-based investment firm
that runs the $234 billion Total Return Fund, is using
strategies in many of its funds to protect against tail events,
said Bhansali, chief architect of the company’s tail-risk
management program.

‘Cheap Protection’

“You don’t want to try to be too smart in trying to
forecast what is going to happen and which hedge is going to
perform better,” said Bhansali, who holds a doctorate in
theoretical particle physics from Harvard in Cambridge,
Massachusetts, and ran the exotic and hybrid options trading
desk at New York-based Citigroup. “What you want to do is
accumulate cheap protection.”

The Pimco Tail Risk Hedging Fund 1 will be the first in a
potential series of partnerships, according to a private
placement filed with the U.S. Securities and Exchange Commission
on June 23. The initial fund will be designed to protect
investors from a drop of more than 15 percent in a benchmark
index that Bhansali declined to identify.

ELVIS

Deutsche Bank is marketing a tail-risk hedging index that
gains in value when investor expectation of stock-market
volatility increases, according to material the bank sent to
clients. The so-called Equity Long Volatility Investment
Strategy, or ELVIS, uses derivatives called variance swaps
linked to the S&P 500 that bet on the index’s volatility.
Derivatives are contracts whose value is tied to assets
including stocks, bonds, commodities and currencies, or events
such as changes in interest rates or the weather.

Citigroup hired John Liu, a former employee of the Indiana
pension fund, about two months ago for a newly formed unit that
will advise pension plans, endowments and foundations on tail
risk hedging, according to a prospective investor who declined
to be named because the hire hasn’t been publicly announced.

Liu was formerly the managing director of equity strategies
at Vanderbilt University, the Nashville, Tennessee-based college
that in late 2005 tried to hedge portions of its endowment by
using tail-risk insurance.

“This has become something of a ‘me-too’ trade lately,”
said Mark Spitznagel, a former Taleb trading partner at
Empirica, who now runs Santa Monica, California-based Universa
Investments LP, which Taleb advises. “These guys are all very
new to a difficult game that we’ve been playing for a very long
time now.”

Costs Rise

Along with the demand, the costs of tail-risk hedging have
also climbed. In June, investors buying options that paid off
should the S&P 500 plunge more than 23 percent from its April
high were paying 75 percent more than those speculating on
gains. The premium was the highest ever, according to data
compiled by Bloomberg and OptionMetrics LLC. Options give
investors the right to buy or sell shares at a predetermined
price.

The risk premiums that investors were willing to pay for
the most bearish options on a European credit index rose to the
most since before Lehman’s collapse. The so-called three-month
volatility skew, a measure of the risk premium for options
trading far from their strike price -- known as out-of-the-money
-- versus those trading close to the strike, reached 30
percentage points on June 4, the highest in at least two years,
and up from 5 percentage points at the end of 2009, Goldman
Sachs Group Inc. data show. The skew has since fallen back to 9
percentage points.

In absolute terms, the cost of an out-of-the-money four-month option giving the right to buy protection against default
by 125 European companies was $930,000 for a $100 million trade
in May, compared with $630,000 yesterday.

‘Sudden Storm’

Goldman Sachs strategists said last month that investors
were overpaying for the derivatives as fears of a sovereign
default in Europe became too extreme, and not paying enough to
hedge against higher-probability scenarios such as a prolonged
period of low growth that spares the financial system while
causing a jump in defaults among the lowest-rated borrowers.

“To put it into sailing terms, investors are paying a high
premium to hedge against a sudden storm,” Goldman Sachs
strategist Alberto Gallo in New York said. “But they’re not
willing to hedge against a prolonged period of no wind. This
creates a buy opportunity for credit.”

Trading in options used to speculate on price swings in
benchmark credit-default swap indexes rose as much as fivefold
last quarter from the beginning of 2010, according to estimates
of activity at Morgan Stanley, said Sivan Mahadevan, global head
of equity and credit derivatives strategy at the firm in New
York.

Bondholder Protection

“It’s one of the most significant credit developments since
2008,” Mahadevan said. “Investors can’t just think of credit
as being a low volatility asset class anymore.”

Credit-default swaps pay the buyer face value if a borrower
fails to meet its obligations, less the value of the defaulted
debt.

Investors should be cautious in following the herd, said
Eric Petroff, director of research at Wurts & Associates, a
Seattle-based consulting firm that oversees about $30 billion on
behalf of institutional investors.

“Products that protect you from tail risk tend to crop up
after the tail has occurred,” he said. “Back in 2007, it made
a lot of sense to hedge tail risk but now it just seems
brilliantly misguided.”

Pine River

Other asset managers that have been hedging against
improbable events are creating funds to take advantage of
demand. Pine River Capital Management LP, a Minnetonka,
Minnesota, firm that has $2.1 billion in assets under
management, started the Nisswa Tail Hedge Fund LP last month,
according to a June 15 filing with the SEC. The partnership was
formed at the request of investors who wanted access to the
hedging techniques used by Pine River’s primary multi-strategy
fund, which gained 40 percent during 2008 and 2009, according to
Aaron Yeary, a co-founder.

“By buying prudent hedges and staying liquid, it allowed
us to be on the offense during the crisis,” said Yeary, who is
running Nisswa Tail Hedge with Nikhil Mankodi. “Some sold their
liquid investments and were left with garbage,” Yeary said,
adding that Nisswa Tail Hedge has about $200 million in assets.

Capula, Ionic

Capula Investment Management started a tail-risk fund in
March with about $100 million, which has grown to about $650
million, according to a person familiar with the fund, who
declined to be identified because the fund details are private.
It may top $1 billion in the next two months, the person said.

Ionic Capital Advisors LLC, a New York-based investment
firm founded by former employees of Highbridge Capital
Management LLC, is offering tail risk protection through Ionic
Select Opportunities Fund LLC, according to a private placement
notice filed with the SEC on June 11. Mary Beth Grover, a
spokeswoman for Ionic, declined to comment.

Taleb said sticking with a tail-risk strategy can be
psychologically challenging because payoffs, while big, are less
frequent.

“If you looked at numbers over a period of time -- six,
seven, eight years -- there’s much higher return,” Taleb said.
“But if you watch a trader in any given year, he looks like an
idiot. No trader wants to feel like he’s an idiot.”